Legal settlements: Limit tax damage
Taxes may be the last thing on your mind when you are embroiled in a messy law-suit. However, depending on the way that a settlement agreement is worded, thousands of extra tax dollars may possibly wind up going to Uncle Sam.
Strategy: Figure taxes into the equation. Draft the agreement in order to minimize your tax liability before you sign it. Remember, once you put your John Hancock on the deal, you’re stuck.
Here’s a key point to remember in the negotiation process. The award to the prevailing party should not be described as “single lump sum.” If you take an all-inclusive amount, you won’t be able to avoid tax on a significant portion of the payout.
Keeping that in mind, here are some helpful tips:
- Describe the settlement in favorable tax terms. Court-awarded reimbursements for medical expenses and personal injuries aren’t taxable. In contrast, punitive damages are taxable as ordinary income. Also, damage awards for nonphysical injuries, such as age or sex discrimination or injury to one’s personal reputation, a generally taxable as well.
- Draft the settlement to describe part of a monetary award as compensation for medical expenses or personal injury. In that way, the allocated portion can escape tax. Conversely, if the settlement is described as a lump sum, including punitive damages and interest, the entire payout is likely to be taxed. The tax difference could be significant.
- Split off payments to your attorney. The tax law says you can deduct attorneys’ fees that are included in a court settlement as miscellaneous expenses on Schedule A. But remember that miscellaneous expenses are subject to a floor on 2% of adjusted gross income (AGI). Besides the 2%-of-AGI floor, these deductions are reduced for certain high-income taxpayers and aren’t included in the calculation for the alternative minimum tax. Generally, the settlement that you receive will be reported on a Schedule 1099-MISC reflecting the entire amount. Therefore, you might request a split award, with one payment going to you and another to your attorney.
Tip: You should include this provision in your contingent-fee contract with your attorney. Make sure the fine print works in your favor.